Log In

Reset Password

Bank failures in the shadow of Fed hikes

Federal Reserve Chair Jerome Powell speaks during a news conference Wednesday, Dec. 14, 2022, at the Federal Reserve Board Building, in Washington. (AP Photo/Jacquelyn Martin)

Last week, the Federal Open Market Committee met at their regularly scheduled meeting which sets the course for US monetary policy. On Wednesday, the committee agreed to lift interest rates by a quarter of a percentage points, representing the 10th rate hike of this business cycle.

The increase takes the fed-funds rate to a target range of 5.00 per cent to 5.25 per cent, the highest since 2007.

While the FOMC's statement hinted at a pause, chairman Jerome Powell said that the central bank was prepared to lift rates higher if needed, and that cuts were unlikely this year. Despite this commentary, the US Treasury yield curve is predicting more than one cut in 2023.

What happens between now and the next FOMC meeting in June will depend on incoming data, a point that Powell made repeatedly in his speech. Importantly, Powell stated: “We on the committee have a view that inflation is going to come down not so quickly, it will take some time. In that world, if that forecast is broadly right, it would not be appropriate to cut rates.”

Powell appeared unconcerned about this year’s multiple regional bank failures, two of which represent the second and third largest in American history. Rapidly rising interest rates have sunk bank investment portfolios while customers yanked deposits in record time.

Four sizeable regional banks became insolvent this year, the last being First Republic Bank which was taken over by J.P. Morgan on May 1. However, Powell views the large bank failures as part of an ongoing financial sector consolidation.

The FOMC is therefore prioritising reputation damage control over financial system stability, and that could lead to further credit deterioration. This Fed believes price stability can only be achieved by flattening economic growth. Because some of this growth has been preordained by massive government spending programmes already in progress, the private sector is more likely to take the hit.

Caught in the economic cross hairs of Powell’s effort to restore lost central bank credibility and the US government’s prolific deficit spending agenda, regional banks have emerged as the most vulnerable components of the market. The KBW regional banking index has declined 29.2 per cent so far this year compared to 7.7 per cent increase in the S&P 500 stock index and its current level is now approaching the pandemic lows of early 2020.

While most financial institutions will survive this downturn, almost all banks will struggle to some degree as customer deposits continue to flow into safer, higher yielding alternatives such as government money market funds. Selectivity is the key to investing in this environment.

Instead of a proverbial “bank run”, one analyst has called the ongoing deposit outflow as a bank walk – slow but steady. Because banks are legally allowed to only lend out a multiple of their deposits, lower deposits will likely mean less lending and that typically leads to slower growth.

JPMorgan CEO Jamie Dimon attempted to ease markets last week saying: "This part of the crisis is over." However, noted economist Mohamed El-Erian disagreed, saying: “The risk of possible additional disruptions to other regional and community banks and the potential collateral damage and the unintended consequences are far from immaterial.”

Meanwhile, another near term risk to the markets this month is the US debt ceiling debate. House Republican efforts to cap soaring public debt levels could potentially shut down America’s deficit spending government and jeopardise America’s creditworthiness. Last Monday, Treasury Secretary Janet Yellen wrote a letter to House leader Kevin McCarthy stating that the Treasury will run out of money as early as June 1.

The Republican-led Congress has passed a debt reduction bill which has been submitted to the White House and further negotiations are pending. The debt ceiling showdown will likely reach its typical brinksmanship early next month, but could then be extended into the summer.

In this environment, we recommend investors remain defensive in both the equity and credit markets. We note that gold is close to a multiyear breakout and could be a beneficiary of the US crisis of confidence. Other currencies such as the Euro and Sterling may also continue their climb against the greenback since last October.

In fixed income, we advise against making a significant bet against the Fed leaving rates higher for longer in this cycle, even as the Treasury yield curve implies otherwise. Short-dated investment grade financial sector bonds look particularly intriguing at current credit spread levels.

Bryan Dooley, CFA, is the Chief Investment Officer at LOM Asset Management Ltd. Please contact LOM at +1 441 292 5000 or visit www.lom.com for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.

You must be Registered or to post comment or to vote.

Published May 10, 2023 at 7:48 am (Updated May 10, 2023 at 7:48 am)

Bank failures in the shadow of Fed hikes

What you
Need to
1. For a smooth experience with our commenting system we recommend that you use Internet Explorer 10 or higher, Firefox or Chrome Browsers. Additionally please clear both your browser's cache and cookies - How do I clear my cache and cookies?
2. Please respect the use of this community forum and its users.
3. Any poster that insults, threatens or verbally abuses another member, uses defamatory language, or deliberately disrupts discussions will be banned.
4. Users who violate the Terms of Service or any commenting rules will be banned.
5. Please stay on topic. "Trolling" to incite emotional responses and disrupt conversations will be deleted.
6. To understand further what is and isn't allowed and the actions we may take, please read our Terms of Service
7. To report breaches of the Terms of Service use the flag icon